Were it not for the costs of changing employment, the optimal level of employment would merely be the amount needed to produce the output of the period. In the theoretical model there was no need to postulate explicitly how employment deviates from this amount, but this must be done for the empirical work.
THE DEMAND FOR MONEY EQUATION
(17) The demand for real money balances is a function of sales and the after-tax short-term interest rate. THE DIVIDEND EQUATION (18)
THE INTEREST PAYMENTS EQUATION (19)
The current level of interest payments of the firm sector is a function of its outstanding debt and of the interest rates that were in effect at the times of the relevant debt issues.
THE INVENTORY VALUATION ADJUSTMENT EQUATION (20)
THE CAPITAL CONSUMPTION EQUATION (21)
The capital consumption of the firm sector is assumed to be a function of the current and past values of nominal investment expenditures, where the lag structure is geometrically declining.
SUMMARY AND FURTHER DISCUSSION
1. Production is smoothed relative to sales. Investment, employment, and hours are smoothed relative to production. The buffer for production is the stock of inventories. The buffer for employment and hours is the amount of excess labour on hand.
2. Although the bond rate is not an explanatory variable in the investment equation, interest rate have indirect negative effects on investment. Interest rates are explanatory variables in the consumer expenditure equations with negative coefficients, and thus an increase in interest rates directly lowers expenditures. This in turn lowers sales, which lowers production and then investment and employment. The main channel by which interest rates affect the economy is through their effects on consumer expenditures.
3. Although interest rates affect investment in the manner just discussed, there is no means in the model by which interest rates affect capital-labour substitution. Any changes in the substitution of capital for labour (or vice versa) brought about by changes in the cost of capital relative to the cost of labour are not explained.